Wednesday, September 2, 2009

Six things I learned from the financial crisis

I started blogging about dividend growth stocks in January 2008; right around the time the market started its slide. Fast forward 18 months and we have seen it all: from companies which were once deemed too big to fail and which were later acquired for pennies on the dollar to the blowups of several prominent pyramid schemes and hedge funds. Back in early 2008 most investors were not fully aware of the dangers that the real estate implosion would have on the overall economy. Some aggressive investors lost much more than S&P 500 in 2008 due to their heavy concentration in certain sectors built at the highs of the market, use of excessive leverage and chasing “broken companies” which offered suspiciously high yields, which proved unsustainable.In order for investors to become better at allocating capital, it is important to learn from ones mistakes. I have identified several mistakes, which could have saved investors billions had they known about them in the first place:

1) Diversify your portfolio. We often hear that diversification is dead and the fact that in a crisis almost all assets go down in sync. While this is somewhat true, a simple diversification strategy where an investor held some allocation to government fixed income, would have resulted in smaller losses. There are several bond ETF’s which hold US Treasuries. Examples include iShares Barclays 20+ Year Treas Bond (TLT) and iShares Barclays 7-10 Year Treasury (IEF). It is also important to understand that simply adding different asset classes in a portfolio may not provide any diversification benefits. For example adding fixed income from High-Yield Bonds would not have provided any diversification benefits, as most junk bonds represent companies with low credit ratings, which have a higher chance of defaulting during a crisis. Several Junk Bond ETF’s such as iShares iBoxx $ High Yield Corporate Bd (HYG) were introduced right before the financial crisis.In addition to that, investors who concentrated their portfolios in just a handful of companies (10 – 15) would have under performed their benchmarks even if they had just one AIG (AIG) or Bank of America (BAC) in it. Both companies were considered the best of the best, before the crisis affected them and they had to seek government funds, while reducing or eliminating distributions to shareholders.

2) Build positions over time. While dollar cost averaging provides inferior returns in strong markets relative to a lump sum investment, the chance of a black swan effect ala 2008 makes it preferable for investors to build their positions slowly. This would be another control that would prevent your portfolio from collapsing, in case your stock analysis didn’t work out as planned.

3) Don’t chase high yield stocks blindly. Back in 2008, many financial stocks had very attractive dividend yields in the low double digits. Some of those like Citigroup (C), Bank of America (BAC) and Fifth Third Bank (FITB) had long histories of consistent dividend increases each year. The problem was that these stocks could not sustain paying their distributions, since they were earning much less than what they were paying out. At the end of the day these companies had nowhere else to go but cut their distributions, which was a strong sell indicator for many dividend growth investors. Most of the dividend cuts in the financial sector were followed by massive implosions in shareholders value from companies such as Citigroup (C), Lehman Brothers, Fannie Mae (FNM) and Freddie Mac (FRE).

4) Don’t use excessive leverage. Using leverage means borrowing money to invest in something for the purpose of magnifying your profit potential. When you are right, leverage works in your favor. For example if you purchased a stock on margin, and it increased 10%, your leveraged return would be almost 20%. When you are wrong though, leverage could result in disastrous results and bankruptcy. Using the same example, a leveraged bet on the wrong side of the table where the underlying fell by 10% results in a 20% loss.The whose housing mess was created by allowing people who cannot afford expensive houses speculating on housing prices enjoying double digit increases for eternity, while being heavily leveraged. Once housing prices started dropping like a rock, panicked sellers helped exacerbate the problem by adding more fuel to the already severe drop in values. This caused interest payments on mortgage backed securities to not be paid, which triggered collapses in financial companies such as Ambac (ABK) and Fannie Mae (FNM) which then sent shockwaves throughout the world.

5) Don’t overpay for stocks. Investors often overpay for stocks because of the recency phenomenon, where they discount double-digit growth indefinitely. This leads to purchasing stocks with unacceptably low dividend yields, high P/E ratios and rosy predictions for strong dividend growth for eternity. Such conditions are simply unsustainable. The so called “Tech Four Horsemen” that CNBC’s “Fast Money” touted in the last quarter of 2007, Apple (AAPL), Research in Motion (RIMM), Google (GOOG) and Garmin (GRMN) all spotted unusually high valuations until growth expectations declined substantially. Investors suffered huge losses in the process.

6) Understand what you are investing into. It is important to understand what one is getting into by reading a prospectus for example. Many mortgage-backed securities were marketed to individuals and institutions as no risk investments. Investors who took the trouble to check the 500-page prospectus of such investments would have avoided severe losses. It is important to keep simple and within your circle of competence. Another example includes some dividend ETFs which were supposed to offer stable income, but which ended up heavily concentrated in financials and REITs. Retirees who depended on those ETFs rather than individual stock selection for income, were caught by surprise. Even the S&P Dividend Aristocrats Index ETF (SDY) and Dow Jones Select Dividend Index (DVY) at some point in time included dividend stocks which shouldn’t have been there. Even now the Dividend Aristocrats Index includes stocks like General Electric (GE), Pfizer (PFE) and Gannett (GCI) which should be avoided by dividend investors.

While this list is not meant to be a comprehensive all-inclusive one, it is a great starting point for both novice and experienced investors. I believe that investing has never been a perfect science, but one could achieve perfection by learning from their mistakes and not repeating them over and over.

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